Should depositary liability extend to CSDs under AIFMD and UCITS V?

As regards the CSDs (central securities depositaries) and depositary banks, where are the risks for the depositaries in assuming strict liability for the restitution of assets of their underlying fund clients in the case of lost assets at a CSD? How likely is this to even happen?

You can see the first part of this article here: AIFMD, UCITS V and depositary liability

“We have been looking at CSDs for a long time and the reason for this is that there are completely different models out there,” explains Jim Micklethwaite, director of capital markets at Thomas Murray Data Services, of some of the work undertaken at Thomas Murray. “Some, obviously, are better than others and the way in which they are structured can result in losses. These losses and risks are not intermediated, generally, by the local and global custodians until UCITS V comes in – then UCITS V will be the game changer.”

Different structures equal different risks and the disparity between Issuer and Investor CSDs means different risks and, also, different behaviours around them. Depositary banks and their fund clients will have no choice over Issuer CSDs in most markets, and the Directives recognise this by not enforcing liability for them upon depositaries. Where there is a choice, as there will be with Issuer CSDs under T2S, there is liability. Also, the behaviour of Investor CSDs in the regulatory world means that they are being forced upstream to offer custodian functionalities, bringing them within the purview of AIFMD.

“This is a key element of the discussion, what type of risk is there at the CSD?” says Koen Vanderheyden, a partner at the law firm DLA Piper. “If there is risk, it will be systemic – it will have a systemic impact. The only way to cover this, to mitigate it, is through settlement finality legislation to ensure settlement finality. If you cannot guarantee settlement finality then you have a source of systemic risk. This is not a risk that can be solved by making depositaries liable for it. It is really absurd to make depositaries liable for the type of risk that you find at CSD level. It should be protected by appropriate legislation and it is absurd to transfer the liability to the depositaries.”

It is not an area that depositaries have previously had any liability for. So what are they taking on? “In terms of risks in CSDs, there are operational risks around the CSD not being able to function properly or experiencing a breakdown in controls and procedures, and then there are key elements to a CSD’s functionality,” explains Jim.

“These are to try to intermediate settlement risk through DVP (delivery versus payment) and to have mechanisms in place – particularly relevant to CSDR (CSD Regulation) – to guarantee settlement and ensure that any failures are dealt with.

“Just in terms of AIFMD and UCITS V, the principal risk is, obviously, asset safety. What we have found is that, if you have a CSD that does not allow for full segregation by beneficial owner, it is highly unlikely that the sub-custodians are going to be doing that, so the CSD sets the ground level for the market in terms of asset protection. Asset safety and segregation are extremely important alongside operational risk, as are proper DVP mechanisms so you do not have a loss of principle because of a counterparty default – I would highlight these as the main risks in CSDs.”

Should depositaries be made liable for any losses occurring via this risk network? As Koen unequivocally states, making depositaries liable for losses occurring out of settlement is a somewhat bizarre way to go. In the drive to further protect investors going forward, however, it was inevitable that liability would extend down to CSDs. Perhaps it could be structured differently, though.

Jim Micklethwaite and Koen Vanderheyden were talking at the Thomas Murray Data Services webinar, Country and Financial Market Infrastructure Risk Monitoring. You can learn more about the session and listen to a re-run here:

Tags: UCITS VAIFMDRegulationCSDDirectiveAsset SegregationSegregationDVP